tracker

Operational Risk: One Standardised Measurement Approach for all Banks

Since Basel II three possibilities have been available for Operational Risk capital calculation within the Pillar I framework: a Basic Indicator Approach (BIA), a Standardised Approach (STA) and an Advanced Measurement Approach (AMA). With the introduction of Basel III not much changed regarding these approaches for Operational Risk capital calculation. Starting in October 2014, however, the Basel Committee stirred up the current regime by publishing the consultation for the revision of the simpler approaches (BCBS291). This proposed set of rules also quickened discussions on the future of the AMA. On 4 March 2016 the long awaited consultancy paper BCBS355 was published shedding light on the matter and clarifying future Operational Risk capital calculation within Pillar I.

 

Revisions to the simpler approaches

In its consultancy paper BCBS291 („Operational risk - Revisions to the simpler approaches“), the Basel Committee suggested a combination of the two „simpler“ approaches (the basic and standardised approach) that were still admissible for Operational Risk capital calculation within the CRR framework besides the Advanced Measurement Approach. Nucleus of this approach was the so called „business indicator“, a combination of P&L-components which was supposed to serve as proxy for Operational Risk. Within the consultation phase, the significance of the proposed improvements as regards risk sensitivity were questioned. Likewise, critics argued that due to its composition the business indicator discriminates against certain business models.  

 

Standardised Measurement Approach for Operational Risk

With the publication of BCBS355 on 4 March 2016, the Basel Committee suggested a new approach, dubbed the „Standardised Measurement Approach“ (SMA). Unlike BCBS291, it not only aims at substituting the simpler approaches but also replaces the Advanced Measurement Approaches (AMA). The SMA is intended to be compulsory for banks, replacing all other approaches. By doing so, the Basel Committee aims at reducing complexity and improving the comparability of capital adequacy between different banks. For the calculation of Operational Risk capital, the SMA combines a „Business Indicator“ - itself composed of P&L-components - with a Loss Component, that comprises internal loss data. The latter, in particular, is introduced with the aim of improving risk sensitivity.

 

Business Indicator

By introducing the Business Indicator the Basel Committee still aims at providing an easy-to-calculate proxy for Operational Risk based on P&L items. The single components, however, were adjusted based on recent criticism raised in the consultation on BCBS291, e.g. the discrimination of business models relying on provision or interest income. The Business Indicator is subdivided into five buckets and translated into a BI Component. Essentially, a rise in the Business Indicator implies a stronger rise in the Business Indicator Component which in turn increases Operational Risk capital (cf. Figure 1). The Basel Committee bases this course of action on conducted empirical analysis.

 

 

Figure 1: Development of the Business Indicator Component in the five bucket structure

 

Loss Component

To further increase the SMA’s risk sensitivity, the Basel Committee introduces a multiplier for buckets two to five. The multiplier draws upon internal loss data that scales a bank’s BI component upwards or downwards. The means to do so is the calculation of a Loss Component incorporating the distribution of average annual losses. To achieve this the SMA distinguishes between loss events smaller than 10 mn EUR or greater than 100 mn EUR, respectively. Table 1 gives an example of three hypothetical distributions of losses with identical total losses. The Loss Component itself is calculated as the sum of average total annual loss (multiplied with a factor of 7), average total annual losses exceeding 10 mn EUR (factor 7) as well as average total annual losses exceeding 100 mn EUR (factor 5).

 

Table 1: example of three hypothetical distributions of losses

 

In order to compute the Internal Loss Multiplier, the Loss Component - in relation to the Business Indicator - enters into the calculation as input of a logarithmic function. Final Operational Risk capital is deduced by multiplying the Internal Loss Multiplier with the aforementioned Business Indicator. Figure 2 shows the Internal Loss Multiplier as a function of the BI Component for the three exemplary loss distributions as introduced in Table 1.

 

Figure 2: Internal Loss Multiplier as a function of the BI component for the three exemplary loss distributions as introduced in Table 1.

 

Comparing the two extremal scenarios A (many small losses) to C (few big losses) it is striking that the distribution exercises only a rather minor effect on the multiplier. Given an equilibrium of total internal losses and the BI Component the multiplier is set to 1. Taking a look at the graphs of scenarios A, B, and C, one can spot that the multiplier is rather insensitive in said region whilst sharply rising in sensitivity as total losses become a multiple of the BI Component. A lower bound of the Internal Loss Multiplier is given at ~0.54.

 

The Basel Committee demands a ten year history of internal losses for the calculation of the Internal Loss Component - a five year observation period is deemed adequate for the initial computation of the SMA given that sound internal loss data extending the five year period is not available. Furthermore BCBS355 includes clarification on minimum standards for the use of internal loss data. If these criteria are not met, the loss multiplier is set to 1, however the Committee reserves the right to impose a higher value.

 

Next Steps

The consultation period on BCBS355 ended on 3 June 2016. Further details concerning the demise of the AMA and the introduction of the SMA will be published in the course of this year.

 

One of the banking community’s main issues at the moment is that the sole Operational Risk management tool considered for the purpose of Pillar I is internal loss data. Hence other useful sources of information are neglected and not reflected in the SMA, e.g. external loss data and in particular forward looking instruments like scenario analysis and key risk indicators, amongst others. Overall this sheds doubt on the risk sensitivity of the SMA as proposed. The main fear is that, due to its simplicity, the SMA might be detrimental to Operational Risk management and the further fostering of understanding Operational Risk within an organisation.

 

We support your business

What do you think about the proposed Standardised Measurement Approach?

  • We’ll discuss with you the potential impact of BCBS355 on your business.
  • We will support you in the analysis and implementation of technical requirements and processual aspects - not only as far as internal loss data collection is concerned.
  • We will support you in the structuring, planning and implementation of projects, to analyse, prioritise and execute your need for action - systematically and holistically based on our well-proven approaches.

 

We’ll gladly discuss these topics with your experts. For further and more detailed information fell free to call us on +49 69 907370 or send an email to oprisk@remove-this.d-fine.de.


An overview on d-fine’s consultancy services pertaining to Operational Risk can be found here.